Hydro One is a buy for long-term share price gains and attractive growing dividends. It’s building a bright future in Ontario and the US.

Hydro One’s shares (TSX—H) are somewhat costly and it carries significant debt. In fact it has a net debt-to-cash-flow ratio of 7.1 times. This is above our usual comfort zone of two times or less. Then again, electricity utilities generate reliable, recurring cash flow. So they can carry more debt than companies with volatile cash flow.

And the debt build-up comes from Hydro One making acquisitions. In such situations, the debt jumps immediately while the extra cash flow shows up only over at least a year. In these cases, we often calculate a company’s net debt-to-equity ratio. Hydro One’s ratio is 1.13 to one. That appears manageable.

Hydro One says that both it and its US acquisition and merger target Avista Corporation (NYSE—AVA) will “maintain healthy balance sheets as well as strong investment-grade credit ratings”. Since Hydro One is issuing equity to help finance the acquisition, we expect it to retain its strong investment-grade credit rating.

Also, its earnings are expected to climb next year and beyond. Particularly as the company makes acquisitions in the US. It pays attractive dividends that yield 3.8 per cent. Hydro One has already raised its dividend once and we expect it to continue to do so and eventually become a ‘dividend aristocrat’.

The Ontario government now owns 49.9 per cent of the company’s shares. As the government’s stake declines, we expect it to become more efficient—like Canadian National Railway and Air Canada. As the government’s ownership drops, Hydro One should become less subject to political expediency. With heavy criticism of Ontario’s electricity costs, Hydro One’s independence matters.

In the six months to June 30, Hydro One earned net income of $284 million, or 48 cents a share. This was down by a fifth from $360 million, or 60 cents a share, a year earlier. President and chief executive officer Mayo Schmidt refers to “implementing operational improvements and efficiency gains across the organization” in the second quarter of 2017.

Even so, several factors worked against Hydro One in the first half. There was much milder weather in its service areas in the first quarter of 2017. This reduced energy consumption and the company’s distribution revenue, of course. Its first-half revenue declined by $203 million, to $3.029 billion. Hydro One’s 2017 allowed-return-on-equity slipped by 41 basis points, to 8.78 per cent. (A basis point is a hundredth of one per cent.) With interest rates on the rise again, we expect its allowed-return-on-equity to rise in the years ahead.

The company faced higher depreciation and interest costs, partly due to long-term debt taken on in its acquisition in Sault Ste. Marie in the last quarter of 2016. It faced higher bad debt costs under revised estimates of uncollectable accounts. Hydro One also incurred higher consulting costs in its ongoing acquisition of Avista Corporation. All this was only partly offset by lower emergency power and storm restoration costs than in the first half of last year.

Avista operate in eastern Washington, northern Idaho and parts of southern and eastern Oregon. Alaska Energy and Resources Company, an Avista subsidiary, provides retail electric service in the city and borough of Juneau. We expect the acquisition to succeed. That’s because Hydro One is offering 24 per cent more than Avista’s previous stock market price.

Hydro One’s cash flow increased by 9.7 per cent in the first half of 2017, to $804 million. This fails to confirm the company’s higher reported earnings in the first half. However, the cash flow fell short of dividends and distributions of $268 million and net capital investment of $745 million.

Hydro One’s earnings are expected to more than recover next year, to $1.31 a share.

The acquisition will pay off fully in 2019

Mr. Schmidt said: “This transaction demonstrates the power and value of the transition into an investor-owned utility, by allowing for healthy expansion into new lines of regulated utility business and new jurisdictions, such as the US Pacific Northwest which is experiencing customer and economic growth.”

Hydro One expects to close the acquisition of Avista in the second half of 2018. It expects this to add to its earnings per share “in the mid-single digits in the first full year of operation”. That is, Avista will add nothing to earnings this year and fairly little next year. It’s in 2019 that the acquisition is expected to pay off.

Hydro One says that Avista’s acquisition “establishes one of North America’s largest regulated utilities with over C$32.2 billion in assets and a leader in electricity transmission and distribution as well as natural gas local distribution businesses”. There’s no overlap between both companies’ businesses. So they expect to keep their existing workforces. Even so, they expect to cut their costs from “efficiencies through enhanced scale, innovation, shared IT [Information Technology] systems and increased purchasing power”. Indeed, buying in bulk would let the combined companies demand and get a better price.

Hydro One plans to finance the acquisition by borrowing US$2.6 billion. It will support this debt by issuing shares for C$1.4 billion. To this end, the company did a bought deal offering of convertible debentures of C$1.4 billion. Under bought deals, the issuers receive the cash and the underwriters assume the risk of selling the securities at a higher price.

Higher earnings lead to higher cash flow and dividends

As Hydro One’s earnings increase in the years ahead, its cash flow should increase as well. this will give it the means to fund its existing operations as well as expand and increase its dividends.

In Canada, companies that raise their dividends for five years in a row are known as ‘dividend aristocrats’. We expect Hydro One to become one in the future.

In the first quarter of 2017, Hydro One raised its dividend by five per cent, to 22 cents a share. This provides an attractive yield of 3.81 per cent.

Hydro One plans to pay dividends of 70 to 80 per cent of its earnings per share. Next year, it’s expected to earn $1.31 a share. This works out to dividends of 92 cents to $1.05 cents a share.

Hydro One expects its acquisition of Avista to pay off fully in 2019. This should enable it to raise its dividend that year too. As its dividends continue to climb, dividend-seeking investors are likely to bid up the price of your shares. That is, you get share price gains on top of a growing stream of dividends.

The consensus recommendation of three analysts is that Hydro One is a ‘buy’. We agree. Buy Hydro One for long-term share price gains and attractive growing dividends.

This is an edited version of an article that was originally published for subscribers in the September 15, 2017, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.